Euroland: ECB Hikes, but Softens Rhetoric
It has been an eventful week with a meeting at the ECB, where, as expected, key rates were raised. This was widely anticipated and so had little impact on the markets. In contrast, the ECB's generally much softer and more balanced tone was not in line with market expectations. The ECB placed much greater emphasis on the downside risks to growth than it did in June, and the rhetoric about the ECB being "in a state of heightened alertness" was omitted. The market reacted with sharp falls of around 25bp in 2Y government bond yields and around 10bp in 10Y government bond yields. As always, the ECB reserved the right to change its rates going forward, but we reckon that the ECB will be on hold until the end of 2009. The ECB faces a dilemma, with inflation well above target on the one hand and a weak growth outlook on the other. This means that our call is associated with an unusual amount of uncertainty.
The coming week's industrial production data for Germany, France and Italy will give us an indication of how the Euroland economy is doing. Germany has fared relatively well to date, although there are signs of the slowdown beginning to kick in. We expect German industrial production to slow further to 3.1% y/y in May. Growth in French industrial production has been relatively stable at a rather lower level. Industrial production in Italy has been falling, but at a slower rate.
Key events of the week ahead
- Monday brings industrial production data for Germany. We predict growth of 3.1% y/y. French and Italian industrial production figures are due on Thursday.
- The week also offers figures for German foreign trade and retail prices, as well as revised GDP data for Euroland on Wednesday.
Switzerland: Inflation Lower than Expected in June
Inflation has been the dominate theme in these articles of late - and this week is no exception. The focus on inflation is no coincidence, and underlines the current relative risk in the Swiss economy. While there have been solid indications that the business cycle has turned, uncertainty has increased on the outlook for inflation and thus on the future monetary policy.
Thursday past saw the release of CPI data for June, which showed that inflation was unchanged at 2.9% y/y, and thus somewhat lower than the consensus expectation of 3.1% y/y. Unchanged inflation surprised on two counts: (i) global oil prices rose almost 10% in June, and (ii) Switzerland's hosting of the European football championship was expected to boost price pressures. However, while oil did indeed again push prices higher, prices on the rest of the consumer basket fell, somewhat surprisingly - though partly as a result of changes in the statistical method. This development is important, not least with respect to the outlook for monetary policy. We have therefore taken a more detailed look at three of the most important inflation channels: wage pressures from the labour market, money supply growth and imported inflation.
Traditionally, a labour market characterised by low unemployment leads to higher wage pressures. In Switzerland, the labour market remains strong, with unemployment at just 2.5% and historically high employment. However, Switzerland has been adept at importing well qualified labour, which has dampened wage pressures. Further, the OECD estimates that the natural level of unemployment is below the current rate, which also helps one to understand the lack of reaction in wages. In the short term, a growing money supply can help stimulate the economy, while, in the longer term, money supply growth that outpaces the trend growth in the economy will result in rising prices. In Switzerland, however, money growth has been limited; over the past four years, M3 has risen by 2.7% y/y on average compared to 8.7% in Euroland. This suggests that inflation is not a pronounced monetary feature in Switzerland and, likewise, credit growth is also lower than in Euroland. Finally, inflation can be imported. EUR/CHF rose significantly from 2006 until the end of 2007, which is also reflected in imported inflation - thus a shift in levels can be seen from Q2 2006. Since then, imported inflation has been running at 3.5% y/y, and as imported goods fill 28.5% of the consumer basket, imported inflation has contributed 1 percentage point a year over the past two years.
Overall then, it seems that the current high level of inflation is primarily imported, and if one disregards the developments in energy and food prices, inflation in Switzerland is in fact very modest - although core inflation has also been driven higher. Where does this leave the SNB? There would not appear to be any necessity to tighten monetary policy as long as one is willing to live with high inflation in the short term, and if one does not expect that the increase in commodity prices will continue. This is precisely the position that the SNB is signalling at the moment. However, the data in the coming months will be decisive for the SNB, and a rate hike in September has not yet been taken off the table, though the more neutral rhetoric of the ECB has reduced the risk of further rate hikes in Switzerland.
Key events of the week ahead
- June unemployment figures due Monday. Focus still on possible indications of a turnaround in the labour market.
USA: Tax Rebates Working! But for How Long?
Following an eventful week with data from both industry and the labour market, we can confirm that the US economy is still stalling. However, the economy does not appear to be as damaged as one might have feared. Industry is shuffling sideways with an ISM around 50, and while the labour market is shedding jobs, the pace of loss is relatively modest. Meanwhile, the "tax cheques" sent to households have had a faster than expected impact. Overall, the economy has managed to navigate through the first half of the year with growth of about 1% compared to H2 07. In other words, a positive surprise compared to expectations at the start of the year - including our own and those of the Federal Reserve. However, this does not mean we have turned more optimistic about the second half of the year - on the contrary.
There are two reasons why the economy has surprised positively. One reason applies mostly to Q1, and it is simply that the underlying economy has been more resilient than expected. The second reason is the timing of the effect of the tax rebates, which applies solely to Q2. The expected impact of the tax rebates had been tinged with much uncertainty, but in recent months retail sales have shown clear signs of the rebates working faster than expected. However, this does not necessarily mean that the overall effect will be greater. As we pointed out in Research USA: A rebate update, 21 May, the effect of the tax rebates will be temporary. In other words, the flipside of the tax rebates is a retreat in consumption growth at a later date. Moreover, the faster and stronger consumers react to the tax package, the more pronounced will be the subsequent retreat in consumption growth. We are very convinced that the higher level of growth in Q2 comes to a very great extent at the cost of growth in Q3. As the other determining factors for consumption - energy prices, wages, unemployment and housing and equity wealth have all deteriorated - we still do not believe that consumers can feel safe. Depending on whether energy prices continue on their current path, there will be a bill to pay in the second half of the year. We would not be surprised to see private consumption stagnate overall - or perhaps even fall modestly - in the latter part of the year. That said, strong exports, low inventories and a gradual stabilisation of the housing market will keep the economy out of recession. You can read more about our new forecast on the front page and in Global Scenarios, July 2008.
Key events of the week ahead
- Most important number in the coming week is the 5-year inflation expectations from the Michigan consumer confidence survey on Friday
- Fed chief Bernanke to speak Tuesday and Thursday
- In the following week, focus will be on the minutes of the latest FOMC meeting, consumer and producer prices, and local activity indices
Asia: Chinese Inflation and Growth Forecasts Revised Up
We have now officially revised up our forecasts for Chinese inflation from 5.5% to 7.1% y/y in 2008 and from 4.0% to 5.0% y/y in 2009. This is due, firstly, to the recent 5-18% hike in energy prices, including oil, which will, in itself, raise inflation by 0.7percentage points. Secondly, we have allowed for an additional energy price hike in our forecast, as oil prices have continued to climb, and Chinese petrol prices are still around 25% below world market levels. Nevertheless, we believe that inflation in China has already peaked, and that it will drop back in the coming months (see chart). Food prices levelled off in June, which should more or less cancel out the increase in energy prices, so we will probably not see a rise in inflation despite the big increase in energy prices. One should remember that food prices are much more important in China than in developed countries. In China, food accounts for 35% of consumption, while energy accounts for only about 5%. In developed countries, food typically accounts for less than 20% of consumption and energy for 7-8%.
As a result, we do not expect the increases in energy prices to have any great impact on growth this year either - especially since the government is stepping up social security expenditure in a number of areas to compensate for the increase in energy prices. We have actually revised up our growth forecast for 2008 from 9.9% to 10.5% y/y. This is primarily due to reconstruction work following the Sichuan earthquake being expected to boost growth temporarily in H2 (see chart). On the other hand, we have revised down our growth forecast for 2009 from 10.1% y/y to 9.7% y/y due to the more negative inflation outlook.
Key events of the week ahead
- G8 meeting in Japan on 7-9 July.
- In China, business confidence data for Q1 are due on Monday, and trade figures for June could also be released by the end of the week.
- In Japan, machinery orders are due Wednesday, and producer prices on Friday.
- In South Korea, we expect a 25bp rate increase to 5.25% at the monetary policy meeting on Thursday.
Foreign Exchange: A Summer Theme
The past week has seen some important events in the money market that also spilled over to the foreign exchange market. The ECB hiked rates by 25bp - as expected - but did not flag any further tightening of monetary policy. This stance was less hawkish than expected, and it sent yields lower and EUR/USD down almost two big figures. Sweden's Riksbank also hiked rates by 25bp, but signalled that several additional increases can be expected - this was significantly more hawkish than expected. Despite this significant shock to interest rates, however, EUR/SEK did not manage to go as low as might have been expected, which perhaps illustrates that underlying flows are generally not SEK-supportive at present. While there have been large shocks to the market lately, our general take on G10 FX remains broadly unchanged.
We have been warning about the dual shock of the financial crisis and economic slowdown since last autumn. There is still nothing to indicate that the financial crisis is over, and cyclical threats to overextended consumers on both sides of the Atlantic should be enough to temper economic optimism. If the two waves of bank and consumer balance sheet repair collide, which now appears to be happening, the consequences could be ugly. On top of this comes rapidly rising inflation, which has become an increasingly important theme on the financial markets - including the FX market.
With oil prices continuing to set new highs we recommend staying with the theme of rising inflation over the summer. This means that central bank willingness to follow through on hawkish rhetoric is likely to be key to currency performance in the near term. Among G10 countries, only the ECB, Norges Bank and Riksbanken are likely to make good on threats to tighten policy further this year. There is also a risk that the RBA and SNB will tighten. In contrast, we do not view forecasts of US, UK or Japanese rate hikes as credible, and we still expect the RBNZ to cut. This suggests that inflation shocks should continue to benefit the former group of currencies over the latter, which is also a key insight in our recently released FX forecast update: To catch a rising tide, 4 July 2008.
Accordingly, we continue to see the risks as being biased towards the upside on EUR/USD given our interpretation of the two central banks' likely reactions, and we are looking for the pair to move towards 1.60 in three months. Further out, however, the fundamental backdrop to both the US and the eurozone appears exceptionally uncertain. Looking at the Japanese yen, we still expect a strengthening during the summer that should take USD/JPY lower, as we are looking for a further pickup in volatility. On the other hand, the yen is receiving little domestic support, as the risk of a recession in Japan is not insignificant, monetary policy is tied down by low (core) inflation, and the political situation is in a mess. All in all, this adds to the risks for this forecast, and we could see EUR/JPY go beyond 1.68. Meanwhile, the other traditional carry funding currency, the CHF, should also see support if volatility picks up in the summer, although relative monetary policy will most likely become a more important driver. If the SNB does not hike rates in September, and the ECB begins to flag a further tightening of monetary policy, this will increase the upside risk on EUR/CHF. However, fundamentals are still pointing to a lower EUR/CHF in the medium-to-long term. Inflation as an important theme in the FX market also implies that potential carry strategies should be considered very selectively. And while we expect support for AUD to remain in place, we are still forecasting a weakening during the summer of both NZD and GBP. More specifically, we are looking for AUD/USD to reach 0.98, NZD/USD to see 0.74 and EUR/GBP to reach 0.82 in three months time.
Looking at the Scandies, the summer could be a difficult period, even though fundamentals are generally continuing to provide support. As demand from commercial clients tends to abate in the summer period, causing the already somewhat thin markets to become even thinner, the upside risk on both EUR/SEK and EUR/NOK will increase due to this higher risk premium.
Fixed Income: Fears of Further Hikes Recede
Fixed income markets continue to find themselves in a manic-depressive state between fears about the financial crisis and worries about high inflation. The past week has illustrated this well - especially in Euroland. Yields in Euroland rose strongly on Monday after inflation numbers surprised on the upside at 4.0% versus an expected 3.8%. However, this was turned on its head after the ECB meeting. While rates were hiked by 25bp to 4.25%, the message going forward from Trichet was much more cautious that the markets had expected. Compared to the rate meeting in June, the ECB expressed greater concern about growth, and the press statement left out several of the passages that contained very hawkish inflation rhetoric. Although the ECB clearly remains concerned about inflation, the impression left was that additional rate hikes are not in the offing (see Flash Comment - ECB: Rate hike but remarkably cautious). This led to a substantial fall in yields on Thursday afternoon, with 2Y government yields falling almost 25bp just after the meeting. As we stated before the meeting, we still expect unchanged ECB rates after Thursday's hike, though the risk in the short term is for additional hikes in the event of oil prices continuing to rise.
US yields retreated over the week as a result of the increasing financial turmoil and more expressions of concern about growth by members of the Federal Reserve. Thus, expectations of coming rate hikes have also been pared back in the US.
The coming week looks rather slimmer as regards important events. Topping the agenda will be the rate meeting in the Bank of England, where we, like consensus, expect an unchanged rate at 5.00%. With global focus directed a little more towards growth concerns and the financial turmoil, we believe that the recent fall in yields could continue in the coming week - especially if equity markets continue to slide.
In our new yield forecast we expect modestly falling rates and steeper curves in both the US and Europe in the coming six months. Oil prices remain a huge joker, though, and still constitute - if they continue to rise sharply - a major risk to our forecast. We generally expect that US bonds will do better until the end of the year. After this, the picture will reverse due to the outlook in the US gradually improving while the European economy will continue to slow (see front page and Global Scenarios, July 2008.)
Commodities: Don't Forget the Demand Side of the Oil Equation
There seems to be only one direction for oil prices at the moment, and it is presumably only a matter of time before they pass the next milestone of USD 150/bbl. Although we have previously been surprised by the capacity of oil prices to keep on climbing, we believe that they will start to peak in the next couple of months, and will be lower in Q4 than they are today.
Fundamentally speaking, the balance between supply and demand appears to have improved when looking 6-12 months ahead. Both the IEA and the US Energy Department are actually predicting a slight increase in non-OPEC production in the coming year, and demand growth also seems to be shifting down a gear. This would mean an increase in OPEC's all-important spare production capacity
It is primarily the effect that soaring oil prices are having on demand that we believe the oil market has "forgotten" to take into account. In reality, what is now happening is that economy agents are finally reacting to high oil prices. We believe this to be due to many now viewing high and rising energy prices as a permanent state of affairs, and to financial/income conditions having deteriorated globally as a result of a tighter credit supply , higher interest rates and high food prices. In the OECD area, demand for oil is actually stagnating. Among the most visible effects are the drop of up to 50% y/y in sales of light trucks in the US, and airlines being forced to keep planes grounded. Petrol consumption in the US is almost 3% down on a year ago.
Outside the OECD area, too - which has been primarily responsible for the growth in oil demand in recent years - we are now beginning to see the consequences of high oil prices. Governments have cut back generous energy subsidies in country after country in the past month, including India, Malaysia, Indonesia, Taiwan and, not least, China, which hiked retail prices by 19% a fortnight ago. This may actually lead to a surge in demand in the short term, as it will ease the shortages that the subsidies previously caused. However, this is unlikely to be the last price increase, and in the longer term it will cause even Chinese demand growth to slow slightly. Clearly, structural demand growth in Asian is not evaporating, but it may be a little slower than previously assumed. This should be enough for the pace of increase in oil prices to ease over the next 3-9 months, and we may even see slightly lower prices as the consequences of lower global growth take effect.
When this so-called demand destruction will begin to set the agenda and put an end to the price spiral is, of course, difficult to say. We expect it to happen in the next 2-3 months, but it may very well be more of a staggered process. Looking beyond our normal 12-month horizon, a fresh imbalance between supply and demand looms in the period 2010-2013. According to the IEA, this period will see an end to growth in non-OPEC oil production, while structural demand for energy will continue to grow in Asia despite high prices. So oil prices may very well end up slightly higher than today when we look beyond the next year.
Danske Bank http://www.danskebank.com/danskeresearch
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